Vikram Pandit, the CEO of Citigroup (NYSE: C), wants more transparency of balance sheet risks at all financial institutions. It is a convenient argument because Citigroup has been forced into a series of disclosures not faced by financial firms that are not banks. Whether his case is logical depends on whether there is undetected risk in the financial system and how it should be benchmarked.

Pandit wrote in the Financial Times that:

As practised, the formal banking sector receives by far the highest level of scrutiny. The rest of the field is left open for the non-bank financial system to serve other customers from outside this regulatory umbrella. And it presumes a level of clairvoyance that no regulator can possess.

His solution is that regulators would create a so-called benchmark portfolio, which would not actually exist, but could be utilized when risk is measured.

He writes:

[I]t would be a collection of real investments that stand in for the kinds of assets that most financial institutions actually hold at the time. What is more, its contents would be 100 per cent public.

All financial firms would be required to show their risk profiles against this hypothetical one. Investors and clients of a financial company could thus determine risk profiles, as the model portfolio would be measured against the portfolios in which they have invested.

Government agencies, which would presumably create the model portfolio, would become ensnared in the debate over what a model portfolio should contain. In the U.S., the Federal Reserve might be asked how the portfolio should be structured. Bank agencies might be asked to do the same. Accounting firms that audit publicly traded financial companies probably would be polled. Retired bank executives might even be asked for their opinions. Arguments arising from the process will make any consensus open to question. Whose interest are satisfied when the model portfolio is created?

The solution to Pandit’s problem is a simple one, if any solution is to be taken at all. Financial firms, large and small, public or private, leveraged or not, would be forced to disclose their entire portfolios and balance sheets. The government would collect the data, and it could be put online like SEC filings. Many firms, like hedge funds, and organizations, such as trading desks, would argue that the disclosure of proprietary data would take away their advantages. It would level the playing field. But in the process, advantages that proprietary undisclosed decisions offer would be lost.

There is risk in the financial system. For financial companies that offer reward to investors, there is also some level of secrecy required. Full disclosure of risk measured against a model, flawed by the nature of how it is created, undermines the entire reason for investing. Hidden risk is an advantage just as much as it is a danger.

Douglas A. McIntyre

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